Wednesday, December 17, 2008

Paul Krugman, NY Times columnist, Professor of Economics at Princeton University, and winner of the 2008 Nobel Prize in Economics, posted an article a couple of hours ago reiterating the approach featured and advocated on this blog a number of times: that deflationary ("liquidity trap") situations require inflationary responses.

Dr. Krugman's post this morning goes into an interesting theoretical detail we should be watching out for -- namely, how the Fed and Treasury are not limited in their response to the crisis with 0% interest rates. They can do more by credibly promising inflation.

Actually, Greg [Mankiw, a Harvard economist] has arrived at the same conclusion I did more than a decade ago, when I tried to model the problems then facing Japan, and now facing us. As I pointed out back then, the essence of a liquidity trap is that the real interest rate is too high, even when the nominal rate is zero. So the theoretically “correct” answer, if you can swing it, is to create expected inflation, pushing the real rate down.

Professor Krugman was roundly criticized for his analysis in the 1990's, however he has of course been vindicated since. A perfect market example of his argument can be found right now in government bonds, "treasuries" -- the recent issue of bonds by the government actually have negative interest rates when traded in the open market between investors. This means investors are willing to guarantee they lose money invested in exchange for the perceived safeness of their investment. Thus, the implication is that the real rate is too high, thereby depressing the economy. (High interest rates depress the economy.)

What we should be most cautious and vigilant about right now are people who are arguing moralism over pragmatism. In other words, let's not cut our noses off to spite our face. Doing so in this case will cause more American children to go hungry, Americans to go without health care, and American families to lose their homes and/or their incomes, which generally undermines family dynamics. We're in the gray here.

Krugman warns:

[Moralists argued that] Japan was supposed to suffer for its sins, not inflate its way out of them. I wonder if similar proposals for the United States will receive the same reception.

If you've heard Tim Pawlenty lately and others seeking a false and cynical "moral high ground" on federal spending (on the heels of our bipartisan government doubling the national debt in the last 8 years, and at the same time governors like him and municipalities plan for more debt and more spending in the face of the crisis), we need to "remember Japan." Let's not make this crisis a decade-long phenomenon.